Essec Business School

Non-financial rating, or ESG rating(for Environmental, Social, and Governance), highlights the way that a technique originally conceived for traditional finance can be used to support companies in improving their corporate social responsibility behavior. 

Rating, i.e. the evaluation and granting of a given indication (note, label, categorization, etc.) by an external organization to the evaluated entity, is a technique that has become established for analyzing credit risk. In concrete terms, companies, financial institutions and public authorities wishing to finance themselves by issuing bonds must first have the securities and the issuer evaluated by credit rating agencies, so that investors know the risk they are exposing themselves. The rationale of this rating was originally strictly financial.

 Given the extent of debt (of corporations, but also countries and local governments) in today’s economy, the role of credit rating agencies has entered public discourse. One doesn’t need to be a finance expert to know that the loss of a “triple A” rating or the classification of a government bond as “speculative” can have significant consequences on a country’s economic policy.

Two conceptions on non-financial rating

Non-financial rating was developed as a consequence of two distinct concerns.

Some investors realized that an organization’s profitability (long-term profitability implies the company’s longevity) relied not only on financial factors (profitability, sustainable debt, sufficient cash flow) but also on non-financial factors, like its ability to attract and retain employees, management quality and effective corporate governance, and its risk management policy, including management of social and environmental risks. These investors wanted to be sure that not only could the company make money, but also that it could do so without its social practices, impact on the environment, and governance hampering its development. 

There are also investors (especially in socially responsible investing - SRI) and interest groups that are principally concerned with the company’s impact on its natural, human and/or institutional environment. They want exemplary companies in which it is possible to invest and thus contribute positively to diverse causes (empowering women or minorities, animal wellbeing, renewable energy, etc.). Conversely, the stigmatisation of companies with poor environmental, social or societal performance tends to force the affected companies to change their strategies and practices.

 These two justifications of non-financial rating coexist today and can result in different rating practices and methods. We can thus distinguish non-financial rating that integrates itself into a broader conception of financial rating, and non-financial rating that pursues a non-financial goal.

A virtuous dynamic based on non-financial rating

In the current climate, companies know the advantages of presenting themselves as virtuous actors, if only to avoid being singled out in the media or in the courts, which would damage their image. 

In addition, governments are careful to promote “good behavior” by companies through the use of incentives rather than coercive measures. Beyond traditional regulation, the government is increasingly looking to influence behavior using disclosure. Companies are required to share their practices and non-financial performance, for example by publishing data on their social policies, their energy consumption, or their waste production, which complements the accounting and financial data. 

When company stakeholders are properly informed about a company’s reality across all dimensions, they can make decisions based on the company’s situation with regards to the criteria they deem pertinent: whether or not shareholders will invest, whether or not the stock exchanges will include the company in specific qualitative index, partners will decide if they want to work with them, customers will decide if they want to consume the goods or services, employees will decide if they want to work there… All of these actors could “vote with their feet”, based on a company’s ratings, and therefore to put pressure on them: but they must have the freedom to do so, which is not always the case.  

The conditions of credible and useful non-financial rating

For this virtuous dynamic to produce the anticipated effects, information on the situation and non-financial performance must be reliable and usable. This is not always the case because companies may be tempted to disclose information that makes them look good, regardless of whether this presents the whole truth. The ghost of greenwashing hovers close by. It is not always easy to compare the information given by different companies given different rating frameworks, so stakeholders may have a hard time making informed decisions.

In concrete terms, the extra-financial information must be produced, processed, synthesized and, at the very least, audited by third parties who are sufficiently independent from the entities being assessed and who have the resources (access to data, capacity to process and analyze data, robust and relevant methodology, etc.) to do a good job.

However, the situation of non-financial rating agencies is quite different from that of financial rating agencies. The financial rating market is monopolized by a few international agencies (S&P, Moody's and Fitch). These agencies are paid by the rated entities, which in practice can hardly access bond financing without using their services. The credit rating agencies are thus recognized, powerful and very profitable companies. This situation consolidates their independence from issuers. Following their involvement in the subprime crisis, credit rating agencies are now regulated, which has not weakened them. They remain key players in finance.

In contrast, non-financial rating agencies appear vulnerable today. The market is fragmented, and agencies tend to operate in a limited geographical region or on a particular theme. Their economic models are diverse and fragile. It is rare that they are directly compensated for their rating by the issuers. Most of the time, they need to provide additional services (advice to issuers, running a stock market index, managing investment funds, disseminating economic information, monitoring controversies, analyzing portfolios, etc.) which can lead to conflicts of interest. Their relative fragility impairs their independence. The diverse methods they use and the heterogeneity of their results damage their credibility.

At a time when sustainable finance increasingly needs to use secure, usable non-financial ratings, it is essential to strengthen non-financial rating agencies. This support could come from the market or from regulation.

Quite logically, the non-financial rating industry is undergoing major changes, driven by the growing use of new technologies (AI, Big Data, etc.), and market consolidation, notably to the benefit of credit rating agencies or players dominating the financial information market. The French non-financial rating agency Arese, which became Vigeo, merged with the Belgian agency Ethibel, then merged with the British agency Eiris before the Moody's group took control in 2019. There is therefore a risk that the non-financial rating agencies integrated into the large traditional financial groups will give up part of their vocation. Aware of these issues, some European regulatory authorities, such as the AMF, have begun to think about strengthening the non-financial data supply industry through a regulation that could guarantee the quality and transparency of ratings and thus strengthen the base of independent European players.

Further reading

H. Bouthinon-Dumas, « Les agences de notation extra-financière et le droit », in H. Bouthinon-Dumas et alii, Finance durable et le droit, Editions IRJS-Sorbonne, 2020, pp.147-174.